The Fed Understands

Willem Butier (via Yves Smith) argues that the Fed’s actions over the past eighteen months has placed its independence at risk:

Without a firm guarantee up front that the Federal government will fully re-capitalize the Fed for losses suffered as a result of the Fed’s exposure to private credit risk, the Fed will have to go cap-in-hand to the US Treasury to beg for resources. Even if it gets the resources, there is likely to be a price tag attached – that is, a commitment to pursue the monetary policy desired by the US Treasury, not the monetary policy deemed most appropriate by the Fed.

Butier’s tone suggests that the Fed is not aware of these risks. But I think the opposite is very much the case – the Fed is agonizing over this issue. See the Fed-Treasury accord that was issued earlier this week; it is a clear effort on the part of the Fed to firmly establish its independence. Note also that some policymakers have made clear their concerns about mixing monetary and fiscal policy. Richmond Fed President Jeffrey Lacker hit on the point this week:

But monetary policy and credit programs do two different things. Monetary policy stabilizes the purchasing power of money over time by keeping the price level stable and relatively predictable, and by doing so, contributes to maximum sustainable economic growth. Credit policy is also aimed at promoting growth, but it is more a form of fiscal policy in that it uses the public sector’s balance sheet to alter the allocation of resources. In this instance, credit market interventions have been financed to a large degree by the issue of new monetary liabilities, but they could just as well be financed with non-monetary liabilities, such as U.S. Treasury securities.

Recall that Lacker dissented at the January FOMC meeting on these ground. San Francisco Fed President Janet Yellen was more clear, reiterating the spirit of the Fed-Treasury accord:

…Critics of the current Fed strategy argue that monetary policy should address only overall credit conditions and should avoid influencing the allocation of credit across particular markets. The joint Treasury-Fed TALF initiative—and even the Fed’s purchases of agency debt and mortgage-backed securities—are controversial because arguably they do affect credit allocation.

A second concern is that close policy coordination between the legislative and executive branches of government may compromise the independence of the Fed, and its credibility and commitment to fulfill its dual mandate of price stability and full employment. For example, at some point, monetary policy goals might require a less accommodate stance of policy, even though credit markets might not be fully healed. The Fed might then face political pressure to keep supplying credit to certain markets…

The principle that a central bank, charged with controlling inflation, should be independent from the government is unassailable. It may also be true that it’s easier for the central bank to guard its independence from political pressure when it mainly holds government securities.

Lacker to Yellen covers a spectrum from hawk to dove, and it seems neither is entirely pleased with the risks the Fed has taken. Truth be told, does anyone like how this crisis has played out? I believe the Fed made a severe ideological error by choosing to ignore asset and credit bubbles on the theory they could easily clean up the subsequent mess. Policymakers are learning that this is easier said then done. But the damage was done, and policy has turned into an atheists in foxholes situation.

At this point, the best the Fed can do is to set the stage to extricate themselves from the situation. For example, note how policymakers will reiterate their intentions to withdraw from financial market when possible – the Wall Street Journal carried such a story Monday:

Fed Chairman Ben Bernanke told community bankers in Phoenix Friday that the central bank’s support would “taper off” once the economy and housing market recover.

“We are very much aware that we don’t want to be in the credit markets forever,” he said. “We need to help them now, but we want to have an exit strategy, and allow those markets to recover and become again fully private sector.”

Yellen hits upon what I think is the greatest risk – that the Fed becomes so entwined in credit markets that they are unable to withdraw liquidity (if, for example, the Dollar plunged or inflation unexpectedly rears up) without undermining particular sectors of the economy, or the credit markets as a whole for that matter. Yellen adds:

As the economy recovers, the Fed will eventually have to reduce the quantity of excess reserves. To some extent, this will occur naturally as markets heal and some programs consequently shrink. It can also be accomplished, in part, through outright asset sales. And finally, several exit strategies may be available that would allow the Fed to tighten monetary policy even as it maintains a large balance sheet to support credit markets. Indeed, the joint Treasury-Fed statement indicated that legislation will be sought to provide such tools. One possibility is that Congress could give the Fed the authority to issue interest-bearing debt in addition to currency and bank reserves. Issuing such debt would reduce the volume of reserves in the financial system and push up the funds rate without shrinking the total size of our balance sheet.

If the Fed has the power to issue bonds, they could soak up excess liquidity without undermining efforts to support credit markets, severing their reliance on Treasury for financing monetary management.

Butier makes another point on the damaging opaqueness of Fed policy:

The Fed can deny and has denied information to the Congress and to the public that US government departments like the Treasury cannot withhold. The Fed has been stonewalling requests for information about the terms and conditions on which it makes its myriad facilities available to banks and other financial institutions. It even at first refused to reveal which counterparties of AIG had benefited from the rescue packages (now around $170 billion with more to come) granted this rogue investment bank masquerading as an insurance company. The toxic waste from Bear Stearns’ balance sheet has been hidden in some SPV in Delaware.

The opaqueness of the financial operations of the Fed in support of the financial sector (which are expanding in scale and scope at an unprecedented rate) and the lack of accountability for the use of taxpayers’ resources that it entails threaten democratic accountability. Even if it enhances financial stability, which I doubt, democratic legitimacy and accountability are damaged by it, and that is too high a price to pay.

Note that, as evidenced by the Fed-Treasury accord, the Fed is as unhappy as Butier about the Maiden Lane Facility, and wants it off their hands. That point notwithstanding, I think Butier is correct to criticize the Fed for secrecy. If the Fed is going to play in the realm of fiscal policy, their actions should be brought to light. Indeed, I am somewhat concerned that giving any more regulatory authority to an institution with such a culture of secrecy is dangerous. If the Fed expects to have a greater – explicit – regulatory role in the future, I think we must demand a greater level of transparency.

Bottom line: The Fed is well aware that their actions have taken policymakers to a place where no respectable central banker wants to tread. They are clearly worried about the risks to monetary independence from their response to the crisis, and rightfully so. I hope too that they are worried about the precedent that we should accept the Fed as an informational black hole in return for Federal Reserve Chairman Ben Bernanke’s commitment to ensure the trains run on time. Butier is right – such a precedent damages the democratic process, and is a high price to pay.